Optimizing Capital Structure Decisions Under the New Tax Law

A major impact of the Tax Cuts and Jobs Act of 2017 for tax-exempt issuers was the elimination of advance refundings of outstanding bonds. Another effect was the increase in the cost of direct bank purchases as financial institutions and other corporate borrowers now have fewer incentives to own tax-exempt debt, thanks to a lower corporate tax rate. In this roundtable, sponsored by TD Bank, several healthcare finance leaders discuss the implications of the 2017 tax law and share their perspectives on optimizing capital structure in a time of far-reaching regulatory changes.

Why is it important for hospitals and health systems to get a handle on the various implications of the new tax law?

Jeff Graff: It was important for Adventist Health System to clearly understand the new tax law so we could measure the impact the legislation would have on our costs and loss of financing flexibility in the future. The direct headline impact of the new tax law to tax-exempt borrowers was the elimination of advanced refunding bonds, which was a mechanism we could leverage to secure lower costs. A secondary and immediate impact of the tax law related to how the legislation affected our banking partners and corporate investors by reducing the maximum corporate tax rate from 35 percent to 21 percent. The lowering of the corporate tax rate introduced the ability for banks in some circumstances to increase borrowing costs to tax-exempt borrowers on existing loans and created an environment in which banks may not be as aggressive or willing to deploy direct placement tax-exempt loans in the future.

Jeffrey Sahrbeck: Since the credit crisis 10 years ago, we at Ponder & Co. have seen banks and other corporate buyers become major participants in the municipal market, especially in the healthcare space. Through private direct placements and the purchase of some public market bonds, they accounted for 30 percent to 40 percent of the overall healthcare market. The change in the tax code will dramatically decrease the value that tax-exempt bonds have for those investors, which will likely lessen their overall demand and increase the interest rate at which they are willing to buy bonds.

For the past few years, many hospitals have relied heavily on the private direct placement market. It was a simple way to enter the market, and the cost was at or slightly below the level of a public market deal. Now with the shift in the tax code, it is going to make those direct placements a lot more expensive—increasing the cost by 50 to 75 basis points. Thus, many healthcare borrowers will need to make the tougher decision between ease of market access and higher cost, when historically they could have both.

How will the tax law changes affect capital structure decisions?

Emmet Conlon: Due to the higher overall cost of capital, it is likely that issuers will be more selective about the projects they choose to finance. Until there is further clarification on the effects of the tax law changes, the sense is that hospitals and health systems will finance projects that are strategically necessary and have the best ROI.

Dustin Matsumori: The tax law changes will affect both initial structuring decisions as well as restructuring of outstanding debt. Organizations pursuing direct purchase structures to issue new debt will be increasingly mindful of the terms and conditions negotiated in bank documents and will strive to preserve as much flexibility in the future by carefully wording definitions and provisions. It is noteworthy that some financial institutions have offered Securities Industry and Financial Association-based (SIFMA-based) pricing for their direct placement structures and have not experienced the same increase in pricing as those institutions whose products are based on a percent-of-London Interbank Offered Rate (LIBOR) pricing model. Others have more lenient provisions for passing through increased costs to borrowers.

Investors benefiting from the lower corporate tax rate may also require higher yields in public market transactions to compensate for the decreased benefit of purchasing tax-exempt securities. As a result, organizations planning to issue new debt in the public market may find that taxable pricing levels, coupled with the flexible use of proceeds, are more attractive.

Similarly, organizations with outstanding debt with optional call provisions that can be refunded for economic savings will need to carefully evaluate the potential economic benefit of proceeding with a taxable refunding in advance of the call date or waiting until a tax-exempt current refunding can be transacted. In addition to issuing taxable debt, several structures are being developed or have been used previously that may gain greater acceptance and would allow an organization to generate economic savings from refunding of outstanding fixed rate transactions prior to their call dates. One such structure is using either internal funds or a line of credit to defease the existing bonds. Another is issuing taxable commercial paper, a taxable floating rate bond, or another short-term taxable bank loan to pay off the existing bonds and then refund the short-term taxable product with a tax-exempt bond at a future date.

How are tax-exempt healthcare issuers dealing with a potential shift in debt strategy as a result of tax changes?

Conlon: For TD Bank, we have seen that it has varied by market. Many clients accelerated the issuance of public fixed rate debt at the end of 2017 to take advantage of the soon-to-be-eliminated advance refundings. We also saw an accelerated issuance of new money in the form of fixed rate debt because of uncertainty regarding the continuation of the tax-exempt debt market for healthcare borrowers, which was ultimately preserved.

In addition to public debt issuance, we recently have seen issuers take advantage of competitive short-term rates by issuing variable rate demand bonds (VRDBs) and standby bond purchase agreements (SBPAs), given the low cost, the prepayment flexibility, and the multimodal structures with those instruments. Some issuers have also explored taxable bond offerings, given the new differential between taxable and tax-exempt rates, as well as the flexibility that those financings provide.

Graff: It stands to reason that the industry will see more healthcare issuers ensuring they have multimodal documents, which is a strategy that Adventist Health System has used for a while. This provides borrowers greater flexibility in the future, especially if we lose the ability to issue tax-exempt bonds in the future.

Sahrbeck: Given the continued market uncertainty, we are advising most organizations to take a wait-and-see attitude on existing variable rate programs or to test the market to see if there is a clear advantage to one product based on bank pricing. Right now, variable rate demand notes (VRDNs) look like a more attractive market based on the variable rate cost of a direct placement versus the all-in costs of a VRDN. However, finance leaders have to make an assumption as to where the SIFMA index will trade as a percentage of LIBOR going forward. Given the significant changes in 2016 to tax-exempt money market funds, the VRDN market and thus the SIFMA index, which is calculated based on the trading level of VRDNs, has been much more volatile for the last two years. Until we have a better idea of where that is going to settle, we are taking a much more measured approach to making any wholesale shifts in clients’ debt composition.

Will liquidity facilities supplant direct purchases as banks’ primary credit product, and how could that affect VRDB supply/demand characteristics in the market?

Matsumori: Intermountain Healthcare has utilized liquidity facilities for much of its puttable debt for more than 15 years. Based on the favorable terms and pricing we receive from the liquidity providers, as well as the low cost of capital offered by the market, we expect to continue utilizing the product as a core component of the capital structure barring significant changes in market dynamics.

Graff: I think it’s quite possible we will see a resurgence in VRDBs. Some believe that the SIFMA index will outperform a percentage of LIBOR going forward, which could lead to more interest from tax-exempt borrowers in traditional VRDB products over direct placements. It also seems reasonable, as a result of tax reform lowering corporate tax rates, that we see bank liquidity facilities become more of a viable financing option than they have been for several years.

That said, a lot will depend on the shape of the yield curve. When the yield curve is flat, borrowers tend to issue longer term fixed rate debt. When the yield curve steepens, we likely will see more health systems seek floating rate debt. When that happens, we are likely to see variable rate demand bonds come back en vogue.

Sahrbeck: In some ways, the money market reforms affected the VRDN market more than the tax code changes affected the tax-exempt market. Until we have real data to indicate what the relationship is between the SIFMA index and LIBOR, and where it will ultimately settle, I don’t believe there will be a huge shift to VRDNs. For new products going forward, VRDNs look more attractive than direct placements; however, I don’t think we would advocate anyone converting wholesale from direct placements into VRDNs given the differences in the structures. VRDNs are backed by a letter of credit or a SBPA, which are typically one- to five-year facilities. One of the advantages of the direct placement market is that it is generally a longer product—five, seven, 10, 15 years. As such, we will likely see a resurgence in the VRDN market but continued (albeit more limited) use of bank direct placement to stretch out the liabilities. Over time, there may even be an equilibrium reached where neither VRDNs nor direct placements will be markedly better than the other.

Conlon: We believe there will always be a market for bank direct purchases. Although demand ebbs and flows, in the long term, it is likely they will remain a relevant part of a system’s capital structure.

Will issuers think about their mix of fixed, variable, and direct lending debt differently?

Conlon: Issuers will continue to be opportunistic in product selection for all financing vehicles in an effort to achieve a balanced capital structure. For borrowers seeking ease of execution, direct lending can be attractive. There could also be more active evaluation of short-term variable rate products while everyone monitors the long end of the curve. Issuers may also consider using taxable debt to remove the administrative burden associated with tax-exempt debt. All that being said, public fixed-rate debt continues to be quite attractive given where rates are.

Matsumori: Although certain structures may not be as attractive as they were prior to tax reform, highly-rated health systems should still have cost-effective alternatives for issuing publicly offered fixed rate, variable rate, and direct lending securities. Conversely, lower-rated hospitals or health systems that have relied on bank debt to fund capital expenditures may find that they have fewer structuring options or that the structuring alternatives available are not as financially beneficial due to increased pricing levels and charges. In such an environment, it will become increasingly important that health systems—especially lower-rated entities—foster strong relationships with their commercial and investment banking partners. Organizations are more likely to negotiate favorable pricing or flexible terms and conditions if their financial partners are able to evaluate the transaction as being part of an ongoing relationship rather than as a one-shot, one-and-done exercise.

Sahrbeck: During the past few years, we have shifted from using the nomenclature fixed and variable to looking at a debt as permanent or contingent capital. Permanent capital is the fixed-rate debt that is expected to be paid off at maturity while contingent debt is any debt with either a put option or a maturity that is expected to be refinanced by a new piece of debt (like many taxable bullet bonds). Nothing in the tax bill has changed the mix of contingent or permanent capital we would recommend. However, the market through a flatter yield curve has significantly limited the value of variable rate debt in terms of the spread between seven-day and 30-year bonds. For the better part of a decade, that spread was 350 to 400 basis points and has now declined to under 150-200 basis points. Thus, healthcare borrowers aren’t being paid to take the risk of variable rate debt, which will have a greater effect on debt selection than the tax code. We would note that the tax changes do illustrate the importance of understanding your bank documents, knowing what your risk tolerances are, and making sure your debt is within those tolerances.

What potential market changes could further complicate these considerations?

Sahrbeck: The biggest potential change would be a prohibition on private activity bonds using tax-exempt financing. That was in the original House bill, which spurred the increased issuance in December 2017. Ultimately, this didn’t make it into the final bill, but we still hear occasional rumblings. If the tax-exempt market were no longer accessible, it would dramatically alter how hospitals and health systems finance themselves going forward.

We also hear alternative thoughts the prohibition on advance refunding is being reconsidered in certain bills and could be pushed back. Reversing that would allow many organizations to get out of some of their debt to lower their cost of funds.

Matsumori: Borrowers must prepare for inevitable challenges in the fixed income market, such as rising interest rates, a flatter yield curve, and the potential for a credit pullback or turmoil. Furthermore, each part of the yield curve has its own supply/demand characteristics. This includes money market funds with durations of less than one year, short-duration funds with durations of two to seven years, and longer term mutual, insurance, and retail funds with durations up to 30 years. Each of these investor segments may experience a dislocation or a potential rise in demand due to a downturn in the equity markets or other factors—thus making the segment more attractive for healthcare issuers.

What strategies should organizations contemplate for optimizing their capital structure?

Graff: Organizations should have a long-term strategy for their debt portfolio. At Adventist Health System, we plan out our debt over multiple years. As we consider our debt portfolio, we aim to closely tie its risk to our balance sheet strength. Our balance sheet strength will directly influence the mix between floating and fixed rate debt. We also have parameters around how much put debt we want to expire in a given year, how much direct bank debt we want in our portfolio, and how much self-liquidity debt we want as an organization, so that five years from now, we have an intentional debt portfolio that fits the risk tolerance we are willing to accept.

Sahrbeck: Diversification in products and maturities/put dates is key. Staggering contingent debt is important. If all an organization’s debt is structured to come due or have a mandatory put in one year, the organization opens itself up to political and market risk in that time period. At the same time, there is value in diversification of products in case market or rules changes affect products differently.

Beyond that, one of the best strategies for finance leaders is to read and understand their governing and legal documents associated with the financing.

Matsumori: I agree. The recent volatility in the market in conjunction with tax reform has created an opportunity to implement more beneficial and flexible terms, conditions, and provisions into legal documents. Some examples include defining additional terms and modes in multimodal documents, evaluating the value of shorter optional redemption or call dates, exploring the idea of having a make-whole call prior to the optional call, and analyzing the benefits, both current and future, of different couponing structures.

Ongoing interaction and communication with rating agencies and the investment community is another essential strategy. We diligently schedule annual discussions with the rating agencies to outline our overall strategies—not just when we are preparing for a financing but every year. We believe this regular, consistent communication ensures that the rating agencies are never surprised by strategic decisions we make or our financial or operational performance.

But the most critical strategy is what the panel has already mentioned: having a long-term perspective that creates and preserves financial flexibility and structuring optionality. We take a long-term view at Intermountain, which has helped us prudently determine which capital structure not only provides a favorable cost of capital today, but also provides the appropriate risk and financial flexibility we desire in the future. For example, although Intermountain has the ability to issue variable rate bonds that are backed by our organization’s own liquidity instead of negotiating an SBPA with a bank, we have made the strategic decision to only issue a limited amount of self-liquidity VRDBs and preserve our balance sheet. By opting to issue SBPA-backed VRDBs, we have maintained significant flexibility to pursue alternate financing structures in the future. Likewise, although we have issued a number of SBPA-backed VRDBs, we have been careful not to concentrate all of our credit and commercial banking business with a single financial institution. Instead, we have negotiated with a diverse group of highly-rated financial institutions as providers of our SBPAs to ensure that we maintain excess credit capacity with all our financial partners.

Conlon: As we’ve discussed, strategic capital deployment is always going to be important. I agree that hospitals and health systems should have a long-term debt strategy based on their risk tolerance and their debt portfolio allocations across fixed and variable rate instruments, as well as bank debt and public issuance. The ability to operate within an ever-changing industry as well as respond to evolving interest rates is vital, so alternative financing’s flexibility should always be considered and valued.

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HFMA Roundtable Participants

Jeff Graff is vice president of treasury for Adventist Health Sunbelt in Altamonte Springs, Fla.

Dustin Matsumori is director of capital markets for Intermountain Healthcare in Salt Lake City.

Jeffrey Sahrbeck is a managing director of Ponder & Co., in Greenwich, Conn.

Emmet Conlon is head of institutional health care and national higher education for TD Bank in New York City.

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